VIX Drop Signals Quiet Close to Tumult of 2008

Receive the latest business updates in your inbox

After a year featuring tectonic shifts in the stock market and the economy, 2008 is set to go out with barely a tremor.

A sudden reversal in trader sentiment about fluctuations in the market over the next 90 days has sent the CBOE Volatility Index (Chicago: VIX) plunging to numbers it hasn't seen since late September, shortly after the collapse of Lehman Brothers.

The reason could well be that investors have had enough of 2008's hysteria and panic and are looking to sit out the rest of the crazy year.

"A lot of people aren't going to be around for the next couple of weeks," said Brian Gendreau, strategist at ING Investment Management in New York. "What I think the market is doing is pricing in that we're not going to have any big moves through the end of the year."

No news could well be good news for a stock market that has lost about 35 percent of its value since Jan. 1.

In recent weeks, Wall Street has withstood thousands of layoffs from the largest companies in the country, billions more being shoveled into bailouts, the Big Three automakers neared collapse--and still stocks have not gone back and staged a significant retest of the Nov. 20 lows.

"A month ago is when we put in the dead lows and since then the S&Ps are up 20 percent, but way more importantly volatility is off by a factor of a half," Jim Iurio, a trading specialist at TJM Institutional Services, said on CNBC. "It seems to be that a little bit of the fear is gone." See Iurio's full comments in the video.

The VIX measures options trading activity and takes a 90-day view of how much fear traders have in the market. The rule of thumb among VIX-watchers is to take the index and divide it by 16 to discern the percentage swing that traders expect for the market in a particular month.

Prior to the credit crisis this year, a VIX above 30 suggested a high level of volatility, and 40 was indicative of a sharp recession.

But with the collapse of the credit markets and the ubiquity of options trading, the VIX soared past 80 at one point in the crisis, suggesting to some that the gauge is not as reliable as it once was--or at least that a paradigm shift has occurred and 80 may be the new 40.

"It used to be much more difficult to buy options. Now it's just commonplace," said Quincy Krosby, chief investment stragest at The Hartford. "Certainly, though, this has been a market of non-ending surprises and negative surprises. When you have the financial landscape changed so dramatically you can understand why investors are going to pay up for protection."

So with plenty of headwinds on the horizon for the market, the downswing in the VIX could be only a temporary phenomenon.

"Investors are saying that the market is on a more even keel right now," Krosby said. "But if you look at it, you'll see investors are paying for downside protection down the road."

To be sure, the index has shown a wide separation from the Standard & Poor's 20-day volatility index of 56.43, something that historically gives way to a spike in the VIX and a move downward for stocks, Todd Salamone, senior vice president at Schaeffer's Investment Research in Cincinnati, told clients in a research note this week.

He also said it is significant that the VIX is trading at half its high point.

"I point this out because important reversal points will sometimes occur at half-highs. As such, the VIX could be setting up for an advance after a sharp decline during the past month," Salamone said. "During the past few months, the market's darkest moments tend to occur when the VIX is trading at a steep discount to the SPX's 20-day historical volatility."

And after all, the low 40s, where the VIX is still trading, still indicates high volatility.

"I would say the VIX at 40 still signals some jitters in the market," ING's Gendreau says. "I can remember the VIX at 40 in the last bear market, and that was supposed to be the end of the world."